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Mastering Business Assets: Depreciation Methods & Tax Strategies

Learn essential depreciation methods, first-year cost recovery options, and tax implications for asset sales. Understand like-kind exchanges and casualty gains to optimize your business assets.

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Mastering Business Assets: Depreciation Methods & Tax Strategies

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  1. Business AssetsChapter 7 pp. 209-252 2012 National Income Tax Workbook™

  2. Business Assets pp. 209-252 • Depreciation basics • First-year cost recovery • Sales of business assets • Installment sales • Like-Kind Exchanges • Casualty Gains and Losses

  3. Learning Objectives p. 209 • Determine if property is depreciable • Explain first-year options • Prepare Form 4797 to report sale • Compute installment sale gain • Decide if exchange is like-kind • Calculate casualty gain or loss

  4. Depreciation Basics p. 210 • Useful life that can be estimated • Owned by taxpayer • Used in trade or business, or held for production of income • Asset placed in service (ready and available for use)

  5. Depreciation Methods pp. 210-212 • MACRS assigns recovery periods and depreciation methods • GDS generally shorter than ADS • ADS is always straight-line • Figure 7.1: Comparisons • ADS is required for some assets

  6. Listed Property pp. 211-212 • Assets with sizeable potential for personal as well as business use • ADS required unless asset is used more than half the time in business • Assets include vehicles, audio and video equipment, computers used outside a business, and so forth

  7. Conventions pp. 212-213 • First and last years’ deductions are less than a full year’s cost recovery • Tangible personal property usually limited to a half-year deduction, but substantial purchases late in year trigger mid-quarter convention • Real estate treated as placed in service in middle of month

  8. Mid-Quarter Convention p. 213 • Look at non-real estate assets placed in service during last 3 months of tax year, no matter how short the year is • If the depreciable basis of those assets > 40% of the basis of all such property placed in service during the year, mid-quarter convention must be used for all of the new non-real estate assets

  9. Avoiding MQ Convention p. 213 • Use of I.R.C. § 179 deduction removes assets from calculation • Example 7.1: Taxpayer must use MQ convention (40.59%) • Example 7.2: Small § 179 election gives taxpayer HY depreciation for other property (40%)

  10. Applying MQ Convention p. 214 • Divide tax year into quarters and assign assets (Example 7.3) • Middle of quarter is 1½ months • Pub. 947 includes tables • Early disposition requires full-year depreciation modification (Examples 7.4 and 7.5)

  11. MACRS pp. 215-216 • Determine recovery class, select GDS or ADS, choose method, establish convention, use tables (Example 7.6) • Early disposition requires adjustment (Example 7.7)

  12. First-Year Options p. 216 • I.R.C. § 179 deduction • Up to 100% of cost • Dollar and investment limits • Business income limitation • Additional first-year depreciation • Up to 50% of cost for 2012 • Can create net operating loss

  13. I.R.C. § 179 pp. 216-217 • More than 50% use in active business • New or used tangible § 1245 property • Acquired by purchase from unrelated party (trade-in basis is not eligible) • Generally cannot be used for assets purchased for lease to others (two exceptions) or by lodging enterprise

  14. I.R.C. § 179 pp. 217 • 2012 dollar limit is $139,000 • Dollar-for-dollar phaseout begins at $560,000 of eligible asset acquisitions (Example 7.8) • Election made at entity level; dollar limit─but not investment limit─also applies at owner level (Example 7.9)

  15. I.R.C. § 179 pp. 217-218 • Separate purchases by partners who contribute only the use of property can boost total deduction (Example 7.10) • Elections by multiple flow-through entities can result in lost deductions (Example 7.11) • For tax years 2003–2012, changes can be made on amended returns

  16. I.R.C. § 179 pp. 218-219 • Business income limit uses aggregate of all business income, such as wages • If joint return is filed, both spouses’ net business income is considered • Taxpayer can elect larger amount, but excess carries forward (indefinite number of years)

  17. I.R.C. § 179 pp. 219-220 • Active trade or business income does not include passive activity or hobby • “Meaningful participation” in business’s management or operation • Examples include Schedule C or F profit or loss, partnership/S corporation flow-through, Form 4797 gains and losses, salaries and wages

  18. I.R.C. § 179 p. 220 • Elected amount reduces asset’s basis, basis in flow-through entity • Recapture required if business use drops to 50% or less • Recapture amount is the excess of the deduction over allowable MACRS • Reported on Form 4797 and business income schedule

  19. Additional First-Year Depreciation pp. 220-223 • Qualifying MACRS property • New property (original user) • Acquired by purchase after 2007 • Placed in service before 2013 • AFYD is default; taxpayer must elect out to avoid its application • Some corporations may use credit

  20. Comparison pp. 221-222 • Used property: § 179 only • 20-year property: AFYD only • Transferred basis: AFYD only • Trigger MQ convention: § 179 only • Limits on amounts: § 179 only • Year (calendar/AFYD; tax/§ 179) • Recapture (all/§ 179; listed/AFYD)

  21. Example 7.12 pp. 222-223 Cost of asset $439,000 § 179 election (139,000) Basis for MACRS $300,000 AFYD (150,000) Remaining basis 150,000 14.29% MACRS (21,435) Total deduction $310,435

  22. Sales of Business Assets p. 223 • § 1231 is best of both worlds • Net gain is treated as capital • Net loss is treated as ordinary • Depreciable and nondepreciable assets if holding period is met • Net all sales on Form 4797

  23. Sales of Business Assets p. 224 • 5-year recapture period if gains follow losses (gain is ordinary income to extent of prior loss) • Example 7.13: Sales in same year are netted; tax benefit is maximized by timing gain in Year 1 and loss in Year 2

  24. § 1245 Property pp. 224-225 • Most depreciable or amortizable property except for buildings • Includes other land improvements • Gain on disposition is ordinary income to extent of prior basis reductions (not just depreciation)

  25. § 1250 Property pp. 225-226 • Depreciable real property that was never and is not § 1245 property • Gain equal to basis reductions in excess of straight-line depreciation is ordinary income • Top tax rate on capital gain equal to straight-line depreciation is 25%

  26. § 1250 Property pp. 225-226 • Gain due to appreciation is taxed at regular capital gain rate • Example 7.14: Gain on pole barn includes ordinary income, § 1250 gain, and other capital gain • Corporations must treat 20% of §.1250 gain as ordinary income

  27. §§ 1252 and 1255 Property pp. 226-227 • 10-year recapture period for soil and water conservation expenses (Example 7.15) • 20-year recapture period for conservation payment exclusion

  28. Form 4797 pp. 227-230 • Part I: § 1231 gains and losses • Part II: Ordinary gains and losses • Part III: Basis reduction recapture (§§ 1245, 1250, 1252, 1254, 1255) • Part IV: § 179, §280F recapture • Examples 7.16 and 7.17

  29. Related Issues p. 231 • Allowable depreciation must be recaptured even if not deducted • File Form 3115 to deduct catch-up amount in year of disposition • Below-market sale is partly a gift • Prorate basis on Form 4797 • File Form 706 to start statute

  30. Installment Sale Rules pp. 231-232 • Seller-financing can spread out taxation of gain on eligible sale • Need to balance tax, credit risks • At least 1 payment in later year • Ordinary income not deferred, regardless of payment received

  31. Installment Sales p. 232 • Selling price: Total value received • Contract price: Sales price minus debt assumed by buyer (not > than basis) • Gross profit: Gain on sale reduced by ordinary income recapture and (for sale of main home) excludable gain • Gross profit percentage: Gross profit divided by contract price

  32. Payments in Year of Sale pp. 232-233 • Debt relief in excess of basis • Buyer’s payment of seller’s costs • Buyer’s note only if is payable on demand or readily tradable • Prior deposit (earnest money)

  33. Installment Sales pp. 233-234 Example 7.18: Sale of machinery Gain $ 150,000 Depreciation (60,000) Gross profit $ 90,000 Gross profit percentage $90,000 ÷ $350,000 = 25.714%

  34. Installment Sales pp. 233-237 Example 7.18: Sale of machine $100,000 × 25.714% $ 25,714 Depreciation recapture* 60,000 Gross income for 2012 $ 85,714 (See Figures 7.12 and 7.13) * Recognized even if no payment

  35. Unstated and Imputed Interest p. 238 • Sellers usually prefer capital gain • Buyers usually want deduction instead of capital expense • Arm’s length transaction generally results in adequate interest so that buyer gets some deduction and seller gets FMV for property

  36. Unstated and Imputed Interest p. 238 • I.R.C. §§ 483 and 1274 require interest on installment sales • IRS publishes AFRs each month • If stated interest is inadequate, part of principal is recharacterized • Lower sales price reduces gross profit, but difference is interest paid by buyer and received by seller

  37. Related Party Resale Rule pp. 238-239 • Installment sale made to related party • Buyer resells property within 2 years but does not pay off installment debt • Seller is deemed to receive resale price up to amount due on contract, thus accelerating gain recognition • Waived if no tax avoidance motive

  38. Like-Kind Exchanges pp. 239 • I.R.C. § 1031 mandates deferral of realized gain in like-kind exchange • Used in business or for income • Not held for personal use • Same nature or character • Report transaction on Form 8824

  39. Like-Kind Exchanges p. 240 • Basis transfers to new property • Boot = cash or unlike property • Boot received is taxable to extent of realized gain • Boot paid increases basis of property received in exchange

  40. Example 7.19 pp. 240-242 FMV received $1,500,000 Basis in old asset $ 800,000 Boot (cash) paid 250,000 Basis transferred (1,050,000) Gain realized $ 450,000 Deferred gain $ 450,000

  41. Example 7.20 pp. 242-243 FMV relinquished $1,250,000 FMV received $1,000,000 Boot received 250,000 Basis transferred (800,000) Gain realized $ 450,000 Gain recognized $ 250,000

  42. Like-Kind Exchange p. 244 • Potential depreciation recapture transfers to new property • I.R.C. § 1031 is not elective • Separate sale can avoid deferral of built-in loss or lower basis for depreciation of new asset • Example 7.21 (Rev. Rul. 61-119)

  43. Casualty Gains and Losses pp. 244-245 • Sudden, unexpected, or unusual • Loss if business asset is destroyed is tax basis minus any recovery • Loss if business asset is damaged is lesser of decrease in FMV or tax basis, minus any recovery

  44. Example 7.22 p. 245 FMV before fire $225,000 Adjusted basis $212,377 Insurance settlement (155,000) Casualty loss $ 57,377 Report on: Form 4684 (Form 4797) Form 1040

  45. Example 7.23 pp. 246-248 FMV before fire $225,000 Adjusted basis $212,377 Insurance settlement (225,000) Casualty gain $ 12,623 If no reinvestment, report on: Form 4684, Form 4797, Form 1040

  46. Example 7.24 pp. 248-250 Cost of bulldozer $125,000 FMV before loss $142,000 Basis (after § 179) 0 Insurance settlement $142,000 § 1245 recapture $125,000 § 1231 gain $ 17,000

  47. Postponement of Gain p. 251 • Reinvest entire proceeds to avoid recognizing any gain • Similar or related in service or use • Attach statement to tax return in gain year and replacement year • Time limits vary from 2 to 5 years

  48. Example 7.25 p. 252 Replacement property $185,000 Insurance settlement (deferred gain) (142,000) Additional cost $ 43,000 Basis in lost asset 0 Basis in replacement $43,000

  49. Questions?

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